Solutions to the Lucas Paradox

The Lucas Paradox draws attention to the fact that capital should flow from rich to poor countries, but that on average the flow is in the other direction.  Lucas’ original (1990) illustration of this phenomenon was couched in terms of a neoclassical model in which two identical countries produce identical goods from a common constant returns to scale production technology.  With all else equal, differences in income per capita reflect differences in capital per capita.  Incomes are lower in the country where capital is more scarce, and returns to capital there are higher to reflect this scarcity.  If capital is allowed to flow freely between the two countries, then the higher returns in the poorer country should bring about a net capital inflow.  So why do we not tend to observe this in the data?  The theoretical literature has identified two main reasons.  The first is due to differences in features of the economy that affect production, including differences in technology, differences in the availability of human capital, differences in the stability of government and differences in the quality of underlying institutions.  The second is due to differences in the functioning of capital markets; even though the expected returns to capital in a given country may be high, a high level of uncertainty associated with the returns may dissuade capital from flowing there.  Recent empirical work has begun to substantiate these theoretical explanations.
Alfaro, L., S. Kalemli-Ozcan, and V. Volosovych, (2008); “Why Doesn’t Capital Flow from Rich to Poor Countries? An Empirical Investigation.” Review of Economics and Statistics 90(2): 347–368. [Working paper version]
Gertler, M., and K. Rogoff, (1990); “North-South Lending and Endogeneous Domestic Capital Market Inefficiencies,” Journal of Monetary Economics 26: 245–266.
Gordon, Roger H., and A. Lans Bovenberg, “Why Is Capital so Immobile Internationally? Possible Explanations and Implications for Capital Income Taxation?” American Economic Review 86: 1057–1075. [Working paper version]
King, R., and S. Rebelo, (1993); “Transitional Dynamics and Economic Growth in the Neoclassical Model.American Economic Review, 83 (1993), 908–931. [Working paper version]
Lucas, Robert E., (1990); “Why Doesn’t Capital Flow from Rich to Poor Countries?” American Economic Review 80: 92–96.
Tornell, A., and A. Velasco, (1992); “Why Does Capital Flow from Poor to Rich Countries? The Tragedy of the Commons and Economic Growth.Journal of Political Economy 100: 1208–1231. [Working paper version]